10th June, 2016
The last grain of sand…
You are sitting on a beach in Copacabana, Rio de Janeiro, enjoying some sunshine and getting away from the pressures of everyday life. For some reason (and just go with it in this example) you are playing with a child’s plastic beach toy, building a sandcastle. Of course, this would be no ordinary sandcastle, you have set yourself up to doggedly attempt to replicate the Empire State Building. As you add sand to the top, and the structure grows, children and families alike stop and watch you in amazement (probably more concerned about why an adult is building a sandcastle at this point). As it grows, you add less and less sand each time, until ultimately it collapses, much to delight of the crowd that’s formed around you.
In this example, it can be argued that the last grain of sand caused the whole structure to topple. So a very small additional input caused a disproportionate result. This type of dynamic has a mathematical name; “chaos theory”. It is the same theory that says slight changes to population dynamics can cause an explosion in economic growth. It has even been argued that a butterfly fluttering its wings in India, can cause a hurricane in the United States.
Avid readers will have noticed our underweight exposure to government bond markets from previous quarterly investment reviews. Despite some eye watering valuations at the start of the year, the asset class has returned another 10% year-to-date. If you have read anything about “negative interest rates” in the press, you will know that in some countries, governments now actually charge you to lend them your money! Doesn’t sound like much of an investment case moving forward, but if you’ve held them you’ve done very well.
Government bonds are a defensive asset class, held for numerous reasons including their safe haven status. So the returns we have seen show that we have a raft of investors extremely worried about the world. They are also forecasting low growth, low inflation and low interest rates for a very, very long time.
I see this as the grains of sand that are currently holding up the sandcastle (bond markets). With everyone positioned so negatively, a small change in fortunes; possibly some hints of inflation, or a boost in spending that in turn pushes corporate profits higher; could cause a disproportionately large market outcome. It’s impossible to say with conviction what will cause it or when that will be, but it does not mean it won’t happen. In fact, often these things harness their own beginning, and it is only after the fact that everyone looks back to understand it.
Our Portfolios have been positioned with nearly no government bond exposure for some time. In our view, the risks surrounding the asset class are clear, and although we are far from predicting the last grain of sand, ultimately it is our job to protect our investors from a sandcastle collapse.